Author: Takashi Kozu, RISB
The Bank of Japan (BoJ) started quantitative and qualitative monetary easing (QQE) in 2013, committing to achieve 2 per cent inflation in two years. Since then, almost three years have passed. But the target has not been achieved, and it is uncertain when it will be. This is why the BoJ has taken the bold step into the realm of negative interest rates.
So, why did the inflation rate fail to rise as initially expected?
In the textbook macroeconomic model, one cannot manipulate the expectations of rational households and firms. Their expectations are supposed to be formed through certain mechanisms. For inflation and deflation, the best-known mechanism today is the modern ‘Phillips curve’, which tells us that the inflation rate will go up when the supply and demand gap of the macroeconomy narrows.
Under the three arrows of Abenomics — monetary easing, fiscal expansion and structural reform — the supply and demand gap of Japan’s economy did narrow, but the trend of inflation failed to rise to 2 per cent. Considering the extraordinary scale of QQE — sometimes referred to as a monetary ‘bazooka’ — it seems unlikely that insufficient easing is to blame for missing the target.
Japan’s economy is under tremendous pressure due to globalisation and its rapidly ageing society. The presence of emerging economies has become even greater and Japanese firms have had to alter their businesses accordingly. The ageing, decreasing population affects both supply and demand sides of the economy. Firms have to find a way to cope with these developments.
As the effects of these structural forces grow, markets take longer to adjust to changes in economic circumstances. As a result, the inflation rate did not go up to 2 per cent as quickly as initially expected. This phenomenon of weaker inflation pressure caused by globalisation and demography is becoming increasingly common among advanced economies.
Recently the global financial market has become very sensitive to the slowing down of emerging economies, and particularly a dampening of economic growth in China. Because of their initial economic successes, these economies are entering a new stage of development with lower growth rates. Many business projects, which assumed vigorous expansion of emerging economies, have become unprofitable and global enterprises have been forced to review their strategies. The risk-off trend in the global financial market have brought cheaper equity prices and lower long-term rates, while characterising the yen as a more valuable, safe-haven currency.
The financial market’s mood has not changed in response to the BoJ’s introduction of negative rates. This may indicate that the market knows Japan’s economic problems cannot be adequately solved by additional financial easing.
It is true that the financial market sometimes swings, causing misalignments of prices that hinders economic activity. It is therefore understandable for authorities that are responsible for economic policy to take actions against bear market sentiments, even when the outcome of actions is not certain. What is theoretically correct is not always the best policy from an implementation point of view. But this does not mean that authorities should take action without calculating the costs and benefits.
The costs of negative policy rates are not yet clear. The benefits of a –0.1 per cent policy rate does not seem particularly impressive, though some distortion in Japan’s bank-centric financial intermediation will be inevitable. Japanese banks as a whole have a vast amount of Japanese government bonds in their portfolio. Returns from these bonds will fall due to the negative policy rate, making them less profitable.
In order to stimulate economic activities and further narrow the supply and demand gap, banks must be prepared to take risks in discovering new business projects. Lower profitability will certainly not be of any help for that.
Negative rates reduce interest payments by the government, at the cost of making banks and institutional investors, like insurance companies and pension funds, less profitable. Despite this, there has been no clear progress in improving the Japanese government’s very poor fiscal condition in the longer term. As insurance and pensions become even more important in Japan’s ageing society, attention must be paid to the implications of negative policy rates for resource allocation.
Considering all these aspects, it is truly difficult for the BoJ to make good new policy decisions while preventing inaction. But this is a time of unprecedented difficulty in the global economy. The global economy is not functioning in the same way as it has in the past, and hence it might not be possible to achieve 2 per cent inflation, at least within the short term. Under such circumstances, the task of the central bank is more difficult than ever and requires unprecedented wisdom.
Article 2 of the Bank of Japan Act states that the BoJ’s currency and monetary control policies should be aimed at achieving price stability, thereby contributing to the sound development of Japan’s economy. This is the bottom line of central bank management. Though its task becomes ever more difficult, the central bank must be wise enough to keep working towards new policy innovations and solutions.
Takashi Kozu is Deputy President and Chief Research Fellow at the Ricoh Institute of Sustainability and Business.